MEC-04--2014-15

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MEC-004: ECONOMICS OF GROWTH AND DEVELOPMENT

Assignment

Course Code: MEC-004

Asst. Code: MEC-004/AST/2014-15

Maximum Marks: 100

Note: Answer all the questions. While questions in Section A carry 20 marks each (to be answered in about 500 words each) those in Section B carry 12 marks each (to be answered in about 300 words each). In the case of numerical questions word limits do not apply.

Section – A

1) Describe the nature of the financial system in a modern economy giving the important types of constituent institutions, markets and instruments. Explain the concept of flow-of-funds in the financial markets.

2) Discuss the Markowitz theory of efficient portfolio selection. How does the CAPM theory build on it?

Section–B

3) Explain the Arbitrage Pricing Theory.

4) Explain the need for, and role of depository systems in secondary markets. Explain the concept of custodial services.

5) Give a theoretical model of central banking, bringing out the relationship between the monetary base and monetary aggregates. What are instruments of monetary policy used by central banks?

6) Compare the impact of monetary policy under fixed exchange rates with those under flexible exchange rates.

7) Discuss the concept of leverage for a firm. Discuss the important financial and leverage ratios used. Explain the Merton-Miller theorem.

Answer Section – A

1) Describe the nature of the financial system in a modern economy giving the important types of constituent institutions, markets and instruments. Explain the concept of flow-of-funds in the financial markets.

Ans.: The economic development of a nation is reflected by the progres of the various economic units, broadly clasified into corporate sector, government and household sector. There are areas or people with

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surplus funds and there are those with a deficit. A financial system or financial sector functions as an intermediary and facilitates the flow of funds from the areas of surplus to the areas of deficit. A Financial System is a composition of various institutions, markets, regulations and laws, practices, money manager, analysts, transactions and claims and liabilities. Financial system comprises of set of subsystems of financial institutions, financial markets, financial instruments and services which helps in the formation of capital. It provides a mechanism by which savings are transformed to investment.

A financial system is the whole congeries of institutions and of institutional arrangements which have been established to serve the needs of modern economy: to meet the borrowing requirements of business firms; individuals and government; to gather and to invest savings; and to provide a payment mechanism. The institutions may be publicly owned or privately owned, may be partnerships or corporations, may be specialized or non-specialized in character. Whatever their legal or economic character, either they have evolved overtime in response to developing needs or they were established. The financial system facilitates transfer of funds, through financial institutions, financial markets, financial instruments and services. Financial institutions act as mobilisers and depositories of savings, and as purveyors of credit or finance. They also provide various financial services to the community. They act as intermediaries between savers and investors. All banks and many non-banking institutions also act as intermediaries, and are called as non-banking financial intermediaries (NBFI). Financial institutions are divided into the banking and non-banking ones. The distinction between the two has been highlighted by characterizing the former as “creators” of credit, and the latter as mere “purveyors” of credit.

The financial system facilitates the transformation of savings into investment and consumption. The financial system performs the following interrelated functions that are essential to modern economy:

It provides a payment system for the exchange of goods and services.

It enables the pooling of funds for undertaking large scale enterprises.

It provides a mechanism for transfer of resources.

It provides a way for managing uncertainty and controlling risk.

It generates information that helps in coordinating decentralized decision-making.

It helps in dealing with the incentive problem when one party has an informational advantage.

The financial system is also particularly important in reallocating capital and thus providing the basis for the continuous restructuring of the economy that is needed to support growth. In countries with a highly developed financial system, we observe that a greater share of investment is allocated to relatively fast growing sectors. When we look back more than one century ago, during the Industrial Revolution, we see that England's financial system did a better job in identifying and funding profitable ventures than other countries in the mid-1800s. This helped England enjoy comparatively greater economic success. The banker and former editor of "The Economist" Walter Bagehot expressed this in 1873 as follows. "In England, however, ... capital runs as surely and instantly where it is most wanted, and where there is most to be made of it, as water runs to find its level".

Nowadays, the lack of a well-developed stock market would be a particularly serious disadvantage for any economy. Equity is essential for the emergence and growth of innovative firms. Today's young innovative high-technology firms will be the main drivers of future structural change essential for maintaining a country's long-term growth potential. The contribution of financial markets in this area is a necessity for maintaining the competitiveness of an economy today given the strongly increased

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international competition, rapid technological progress and the increased role of innovation for growth performance.

In recent years, "new markets", for stocks of young and growing companies, have become a growing market segment in the euro area. Equity financing is particularly advantageous for these companies and their investors given the uncertainties of the economic return. As the term "shares" suggests, with equity financing you get your share of the outcome, whether it is positive or negative. Banks, on the other hand, may be reluctant to provide loans owing to the risk profile of these firms, and the greater exposure to a negative result in a loan contract.

Total market capitalisation of the new markets in five euro area countries grew from EUR 7 billion at the beginning of 1998 to EUR 167 billion in December 2000. While some of this increase can be attributed to the overall rise in share prices during this period, it is important to note that the number of listed companies continued to increase in almost every month. The total number of companies listed on these new markets in the euro area increased from 63 at the beginning of January 1998 to 564 at the end of 2000. Developments over the last year have admittedly been dismal. However, it is the nature of new markets, given the uncertainties attached to future developments for the companies listed on these markets, to exhibit more volatility than established markets.

In the financial system funds flow from those who have surplus funds to those who have a shortage of funds, either by direct, market-based financing or by indirect, bank-based finance. The former British Prime Minister William Gladstone expressed the importance of finance for the economy in 1858 as follows: "Finance is, as it were, the stomach of the country, from which all the other organs take their tone."

The financial system comprises all financial markets, instruments and institutions. Today I would like to address the issue of whether the design of the financial system matters for economic growth. My view is that the answer to this question is yes. According to cross-country comparisons, individual country studies as well as industry and firm level analyses, a positive link exists between the sophistication of the financial system and economic growth. While some gaps remain, I would say that the financial system is vitally linked to economic performance. Nevertheless, economists still hold conflicting views regarding the underlying mechanisms that explain the positive relation between the degree of development of the financial system and economic development.

Some economists just do not believe that the finance-growth relationship is important. For instance, Robert Lucas asserted in 1988 that economists badly over-stress the role of financial factors in economic growth. Moreover, Joan Robertson declared in 1952 that "where enterprise leads, finance follows". According to this view, economic development creates demands for particular types of financial arrangements, and the financial system responds automatically to these demands.

2) Discuss the Markowitz theory of efficient portfolio selection. How does the CAPM theory build on it?

Ans.: The process of selecting a portfolio may be divided into two stages. The first stage starts with observation and experience and ends with beliefs about the future performances of available securities. The second stage starts with the relevant beliefs about future performances and ends with the choice of portfolio. This paper is concerned with the second stage. We first consider the rule that the investor does

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(or should) maximize discounted expected, or anticipated, returns. This rule is rejected both as a hypothesis to explain, and as a maximum to guide investment

.behavior. We next consider the rule that the investor does (or should) consider expected return a desirable thing and variance of return an undesirable thing. This rule has many sound points, both as a maxim for, and hypothesis about, investment behavior. We illustrate geometrically relations between beliefs and choice of portfolio according to the "expected returns-variance of returns" rule.

For selection of the optimal portfolio or the best portfolio, the risk-return preferences are analyzed. An investor who is highly risk averse will hold a portfolio on the lower left hand of the frontier, and an investor who isn’t too risk averse will choose a portfolio on the upper portion of the frontier.

One type of rule concerning choice of portfolio is that the investor does (or should) maximize the discounted (or capitalized) value of future returns. Since the future is not known with certainty, it must be "expected" or "anticipatded7' returns which we discount. Variations of this type of rule can be suggested. Following Hicks, we could let "anticipated" returns include an allowance for risk. Or, we could let the rate at which we capitalize the returns from particular securities vary with risk.

The hypothesis (or maxim) that the investor does (or should) maximize discounted return must be rejected. If we ignore market imperfections the foregoing rule never implies that there is a diversified portfolio which is preferable to all non-diversified portfolios. Diversification is both observed and sensible; a rule of behavior which does not imply the superiority of diversification must be rejected both as a hypothesis and as a maxim.

Modern portfolio theory (MPT)—or portfolio theory—was introduced by Harry Markowitz with his paper “Portfolio Selection,” which appeared in the 1952 Journal of Finance. Thirty-eight years later, he shared a Nobel Prize with Merton Miller and William Sharpe for what has become a broad theory for portfolio selection.

Prior to Markowitz’s work, investors focused on assessing the risks and rewards of individual securities in constructing their portfolios. Standard investment advice was to identify those securities that offered the best opportunities for gain with the least risk and then construct a portfolio from these. Following this advice, an investor might conclude that railroad stocks all offered good risk-reward characteristics and compile a portfolio entirely from these. Intuitively, this would be foolish. Markowitz formalized this intuition. Detailing a mathematics of diversification, he proposed that investors focus on selecting portfolios based on those portfolios’ overall risk-reward characteristics instead of merely compiling portfolios from securities that each individually have attractive risk-reward characteristics. In a nutshell, inventors should select portfolios not individual securities.

If we treat single-period returns for various securities as random variables, we can assign them expected values, standard deviations and correlations. Based on these, we can calculate the expected return and volatility of any portfolio constructed with those securities. We may treat volatility and expected return as proxy’s for risk and reward. Out of the entire universe of possible portfolios, certain ones will optimally balance risk and reward. These comprise what Markowitz called an efficient frontier of portfolios. An investor should select a portfolio that lies on the efficient frontier.

Section–B

3) Explain the Arbitrage Pricing Theory.

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Ans.: In finance, arbitrage pricing theory (APT) is a general theory of asset pricing that holds that the expected return of a financial asset can be modeled as a linear function of various macro-economic factors or theoretical market indices, where sensitivity to changes in each factor is represented by a factor-specific beta coefficient. The model-derived rate of return will then be used to price the asset correctly - the asset price should equal the expected end of period price discounted at the rate implied by the model. If the price diverges, arbitrage should bring it back into line.

The arbitrage pricing theory (APT) describes the price where a mispriced asset is expected to be. It is often viewed as an alternative to the capital asset pricing model (CAPM), since the APT has more flexible assumption requirements. Whereas the CAPM formula requires the market's expected return, APT uses the risky asset's expected return and the risk premium of a number of macro-economic factors. Arbitrageurs use the APT model to profit by taking advantage of mispriced securities. A mispriced security will have a price that differs from the theoretical price predicted by the model. By going short an over priced security, while concurrently going long the portfolio the APT calculations were based on, the arbitrageur is in a position to make a theoretically risk-free profit. The theory was proposed by the economist Stephen Ross in 1976.

4) Explain the need for, and role of depository systems in secondary markets. Explain the concept of custodial services.

Ans.: In the secondary market, the depository through participants as a link between the investor and dealing house of the exchange to facilitate settlements of the security transactions through book- keeping entries. Further, the depository can provide ancillary services like collecting dividends and interests and reporting corporate information. In India the need for setting up a depository was realised after the large scale irregularities in securities transactions of 1992 exposed the limitations of the prevailing settlement system. The need for depository system was also realised for the healthy growth of primary market, which would reduce the time between the allotment of shares and transfer of entitlements arising out of each allotment. As India has a large number of listed company involving a massive amount of paper work, there have been stolen share., forged/fake certificates, etc., which pose a threat to the security of investment. The idea of setting up a depository and the introduction of scrip less trading and settlement were thus conceived for improving the efficiency of the markets and eliminating the various problems associated with dealing in physical certificates. A depository system benefits the investing public, the issuers of securities, the intermediates and the nation as a whole.

The move on depository system in India was initiated by the Stock Holding Corporation of India Limited (SHCIL) in July 1992 when it prepared a concept paper on “National Clearance and Depository System” in collaboration with Price Waterhouse under a programme sponsored by the U.S. Agency for International Development. Thereafter, the Government of India constituted a Technical Group under the Chairmanship of Shri R. Chandrasekaran, Managing Director, SHCIL, which submitted its Report in December 1993. The Securities and Exchange Board of India (SEBI) constituted a seven-member action squad subsequently to discuss the various structural and operational parameters of Depository System. Considering the various problems and issues, the Government of India promulgated the Depositories Ordinance in September -1995, thus paving the way for setting up of depositories in the country. The Depositories Act was passed by the Parliament in August 19%, which lays down the legislative framework for facilitating the dematerialisation and book entry transfer of securities in a depository. The Act provides that a depository, which is required to be a company under the Companies Act, 1956, and depository participants (i.e. agents of the depository) need to be registered with SEBI. The depository

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shall carry out the dematerialisation of securities and the transfer of beneficial ownership through electronic book entry.

5) Give a theoretical model of central banking, bringing out the relationship between the monetary base and monetary aggregates. What are instruments of monetary policy used by central banks?

Ans.: To this point we've been a little cavalier about money and financial markets, ignoring the distinctions between currency and monetary aggregates (M in our theories) and the roles played by financial institutions in channeling saving to firms and governments, domestic and foreign. In the next two classes we'll rectify some of these oversights, and take a closer look at banking, financial intermediation more generally, and monetary policy in the US and around the world. With apologies to Goldman Sachs, the word "bank" will generally be used to mean commercial bank in this Chapter of the notes.

Financial intermediaries are "middle-men" (or with less gender bias, "middle-people") who funnel funds from sources of funds (savers, foreign investors) to users (business, government). In principle, savers could purchase assets directly from users, as when an individual buys a treasury bill or share of stock. But in practice, most funds flow through intermediaries of various types: commercial banks, thrift institutions, pension plans, insurance companies, and so on. Investment banks play a role here, too, and also help to match borrowers and lenders.

Fiduciary or paper money is issued by the Central Bank on the basis of computation of estimated demand for cash. Monetary policy guides the Central Bank’s supply of money in order to achieve the objectives of price stability (or low inflation rate), full employment, and growth in aggregate income. This is necessary because money is a medium of exchange and changes in its demand relative to supply, necessitate spending adjustments. To conduct monetary policy, some monetary variables which the Central Bank controls are adjusted-a monetary aggregate, an interest rate or the exchange rate-in order to affect the goals which it does not control.

Reserve Requirement: The Central Bank may require Deposit Money Banks to hold a fraction (or a combination) of their deposit liabilities (reserves) as vault cash and or deposits with it. Fractional reserve limits the amount of loans banks can make to the domestic economy and thus limit the supply of money. The assumption is that Deposit Money Banks generally maintain a stable relationship between their reserve holdings and the amount of credit they extend to the public.

Open Market Operations: The Central Bank buys or sells ((on behalf of the Fiscal Authorities (the Treasury)) securities to the banking and non-banking public (that is in the open market). One such security is Treasury Bills. When the Central Bank sells securities, it reduces the supply of reserves and when it buys (back) securities-by redeeming them-it increases the supply of reserves to the Deposit Money Banks, thus affecting the supply of money. Lending by the Central Bank: The Central Bank sometimes provide credit to Deposit Money Banks, thus affecting the level of reserves and hence the monetary base.

6) Compare the impact of monetary policy under fixed exchange rates with those under flexible exchange rates.

Ans.: Suppose the US fixes its exchange rate to the British pound at the rate Ē$/£. This is indicated on the adjoining diagram as a horizontal line drawn at Ē$/£. Suppose also that the economy is originally at a super equilibrium shown as point F with original GNP level Y1. Next, suppose the US central bank, the

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FED, decides to expand the money supply by conducting an open market operation, ceteris paribus. (Ceteris paribus means that all other exogenous variables are assumed to remain at their original values). A purchase of treasury bonds by the FED will lead to an increase in the dollar money supply. As shown in section 60-4, money supply changes cause a shift in the AA-curve. More specifically, an increase in the money supply will cause AA to shift upward (i.e., ↑MS is an AA-upshifter). This is depicted in the diagram as a shift from the red AA to the blue A’A’ line.

The money supply increase puts upward pressure on the exchange rate in the following way. First, a money supply increase causes a reduction in US interest rates. This in turn reduces the rate of return on US assets below the rate of return on similar assets in Britain. Thus, international investors will begin to demand more pounds in exchange for dollars on the private FOREX to take advantage of the relatively higher RoR of British assets. In a floating exchange system excess demand for pounds would cause the pound to appreciate and the dollar to depreciate. In other words, the exchange rate E$/£ would rise. In the diagram this would correspond to a movement to the new A’A’ curve at point G.

However, because the country maintains a fixed exchange rate, excess demand for pounds on the private FOREX will automatically be relieved by FED intervention. The FED will supply the excess pounds demanded by selling reserves of pounds in exchange for dollars at the fixed exchange rate. As we showed in Section 70-x, FED sales of foreign currency results in a reduction in the US money supply. This is because when the FED buys dollars in the private FOREX, it is taking those dollars out of circulation and thus out of the money supply. Since a reduction of the money supply causes AA to shift back down, the final effect will be that the AA curve returns to its original position. This is shown as the up and down movement of the AA curve in the diagram. The final equilibrium is the same as the original at point F.

The AA curve must return to the same original position because the exchange rate must remain fixed at Ē$/£. This implies that the money supply reduction due to FOREX intervention will exactly offset the money supply expansion induced by the original open market operation. Thus, the money supply will temporarily rise, but then will fall back to its original level. Maintaining the money supply at the same level also assures that interest rate parity is maintained. Recall that in a fixed exchange rate system, interest rate parity requires equalization of interest rates between countries (i.e., i$ = i£). If the money supply did not return to the same level, interest rates would not be equalized.

Thus, after final adjustment occurs, there are NO EFFECTS from expansionary monetary policy in a fixed exchange rate system. The exchange rate will not change and there will be no effect on equilibrium GNP. Also since the economy returns to the original equilibrium, there is also no effect upon the current account balance.

Contractionary monetary policy corresponds to a decrease in the money supply or a FED sale of treasury bonds on the open bond market. In the AA-DD model, a decrease in the money supply shifts the AA-curve downward. The effects will be the opposite of those described above for expansionary monetary policy. A complete description is left for the reader as an exercise.

The quick effects however, are as follows. US contractionary monetary policy with a fixed exchange rate will have NO EFFECTS within the economy. E$/£, Y$ and the current account balance will all be maintained or return to their initial levels.

7) Discuss the concept of leverage for a firm. Discuss the important financial and leverage ratios used. Explain the Merton-Miller theorem.

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Ans.: A company that uses debt in its capital structure. The term often refers to firms that have a large percentage of debt relative to equity when compared against peers in the same industry. Many financiers believe that the optimum capital structure requires some level of borrowing, though the exact percentage will vary depending on the industry and management's preferences. However, companies that do not have debts on their balance sheets tend to survive better in a recession. The use of borrowed money to increase production volume, and thus sales and earnings. It is measured as the ratio of total debt to total assets. The greater the amount of debt, the greater the financial leverage.

Since interest is a fixed cost (which can be written off against revenue) a loan allows an organization to generate more earnings without a corresponding increase in the equity capital requiring increased dividend payments (which cannot be written off against the earnings). However, while high leverage may be beneficial in boom periods, it may cause serious cash flow problems in recessionary periods because there might not be enough sales revenue to cover the interest payments. Called gearing in UK. See also investment leverage and operating leverage.

A company that uses any debt to help finance its operations. Most companies are leveraged to some degree, but others take on so much debt they have difficulty servicing it and may file for bankruptcy. Highly leveraged companies often have more volatile profits than other companies. Some analysts, however, dispute the idea that leverage (or the lack of it) affects a company's performance in any way. See also: Capital Structure, Capital Structure Irrelevance Principle.

The Modigliani–Miller theorem (of Franco Modigliani, Merton Miller) is a theorem on capital structure, arguably forming the basis for modern thinking on capital structure. The basic theorem states that, under a certain market price process (the classical random walk), in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed.[1] It does not matter if the firm's capital is raised by issuing stock or selling debt. It does not matter what the firm's dividend policy is. Consequently the Modigliani–Miller theorem is also often called the capital structure irrelevance principle.

The key Modigliani-Miller theorem was developed in a world without taxes. However, when the interest on debt is tax deductible, and ignoring other frictions, the value of the company increases in proportion to the amount of debt used. And the source of additional value is due to the amount of taxes saved by issuing debt instead of equity.

Modigliani was awarded the 1985 Nobel Prize in Economics for this and other contributions.

Miller was a professor at the University of Chicago when he was awarded the 1990 Nobel Prize in Economics, along with Harry Markowitz and William Sharpe, for their "work in the theory of financial economics," with Miller specifically cited for "fundamental contributions to the theory of corporate finance."

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MEC-04--2014-15